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Fed clambers back to positive real rates, now debate is when to stop

The Federal Reserve will likely raise its target interest rate to above the rate of inflation for the first time in a decade next week, igniting a new debate: when to stop.

The Fed has been gradually hiking rates since late 2015 with little sign of tighter conditions hampering economic recovery. The expected June increase will raise the stakes as the Fed seeks to sustain the second-longest U.S. expansion on record while continuing to edge rates higher.

With inflation still tame, policymakers are aiming for a “neutral” rate that neither slows nor speeds economic growth. But estimates of neutral are imprecise, and as interest rates top inflation and enter positive “real” territory, analysts feel the Fed is at higher risk of going too far and actually crimping the recovery.

The Fed is “gradually entering a new world when rates are at 2 percent,” nearing zero on a real basis and approaching where they are no longer felt to be stimulating economic activity, said Thomas Costerg, senior U.S. economist at Pictet Wealth Management.

The last time rates moved into positive real territory on a sustained basis was the spring of 2005 when the Fed began tightening rapidly after a period of arguably too-lax monetary policy, ending just months before the start of the 2007-2009 financial crisis.

The debate over the current cycle’s end point “came earlier than I expected,” Costerg said, with the Fed facing imminent calls on where the neutral rate of interest lies.

After the expected June increase the Fed’s target interest rate will be set at a range of between 1.75 percent and 2 percent, matching the Fed’s inflation target and roughly in-line with the latest inflation data. That translates to a real rate of roughly zero and is already at neutral, according to some policymakers who feel the Fed should stop hiking now.